A Business Case for Extended ESOP Exercise Windows

Employee Stock Options Programs (ESOPs) are commonplace in the startup ecosystem, with nearly every startup in the USA and Europe, including Prisma, implementing some form of ESOP. They evoke a wide range of opinions and emotions, and their consequences have become a source of folklore and myths. Some perceive ESOPs as a means to extraordinary wealth, while others regard them as mere lottery tickets or tools to persuade employees to accept lower salaries. These differing views are a reflection of the reality shaped by the design of ESOPs.

This blog post aims to discuss the concept of 90-day exercise windows in programs and explain why we decided to extend this period to 10 years at Prisma. We believe that this change is not only fair to our team, but also a good business decision.

The problem with 90-day exercise windows

Exercise windows are the amount of time a team member has to exercise their stock options after leaving a company before they are forfeited and returned to the stock option pool, and according to Carta, in Q4 2022 ~83% of companies follow a 90-day exercise window.

Startup employees have widely criticized 90-day exercise windows. One critique comes from Zach Holman in his colorful blog post published back in 2016. As Holman points out, 90-day exercise windows impose a financial burden on employees leaving the company, requiring them to use their own money to exercise their stock options in exchange for shares in a notoriously risky investment. This is even worse in some European countries, such as Germany, where Capital Gains Tax is applied to unrealized gains. Suddenly, employees not only have to find the money to exercise their options, but they also need to pay the accompanying tax bill. Added together, the exercise of stock options and the accompanying taxes could be tens to hundreds of thousands of dollars in some instances.

It's easy to understand why many employees have been skeptical about the value of ESOPs, and some have accused these plans of being disproportionately favorable to team members from rich families, possibly perpetuating wealth inequality.

To address this situation, some companies — including Prisma — have opted to extend the exercise windows for their teams. This extension ranges from 10 years to shorter time periods. You can find a list of some of these companies here on GitHub.

Why we chose a 10-year exercise window

Prisma was established in 2016, then known as Graphcool. Similar to many other companies, we followed the standard 90-day exercise period. In 2021, with unanimous support from our Board of Directors, we extended our ESOP exercise window to 10 years, and in line with our value of Transparency, we also published this on our careers page.

This decision stemmed from our commitment to our team, recognizing the critical contributions of current and former team members in our success, and a belief that everyone who contributed to Prisma should have an opportunity to benefit from its success.

Our 10-year exercise window reinforces this belief by providing past team members with:

• additional time to improve their personal financial situation before needing to exercise their stock options;
• time for more information to be gained about Prisma’s prospective success and thereby
• reducing the overall risk of the investment.

Finally, this change benefited many of our team members based in Berlin, Germany, where we previously had our largest office. Unfavorable German tax laws affected a significant number of our team, and this adjustment helped them avoid extraordinarily high tax payments if they were to exercise their options upon departure.

Although extended exercise periods are popular with employees, there are ample critics who have valid concerns about this approach, as illustrated by this post from Andreessen Horowitz.

Criticism of extended exercise windows

From a fairness perspective, critics have pointed out that the longer exercise period will perpetuate a wealth transfer. Former team members, who are no longer contributing to the company can hold on to their options for an extended period, benefiting from the work of current team members.

From an economics perspective, it is argued that the prolonged exercise window may lead to an increased rate of dilution for current employees.

Dilution is the decrease in ownership percentage for existing shareholders when a company issues or reserves new shares of stock. — (Carta)

It is argued that dilution would be amplified because of former employees retaining their options, forcing the company to refresh the option pool more frequently to attract new talent or incentivize existing team-members. This dilution can impact the ownership percentage of current team members in the company.

These concerns are not entirely wrong, and could be mitigated by a change in perspective, and some adjusted financial modelling. Below are a few perspectives we hod at Prisma seeks a compromise between the interests of current team-members, former team-members, founders, investors, and other shareholders.

About fairness: Standing on the shoulders of giants

The concern raised by critics about "wealth transfer" overlooks a fundamental issue. Many new and current team members can only join a company because of the success achieved by those who came before them. It also seems unfair that a team-member who joined when the startup was just starting out should have to take a much bigger financial risk to make money from their stock options compared to an employee who joined later. One way to address this is by offering larger stock option grants to early-stage employees, typically coupled with a lower exercise price. This is intended to serve as compensation for the risk involved.

However, some people argue that employees in the early stages should accept lower salaries in exchange for these bigger stock option grants. This means that early-stage employees have to accept both lower salaries and more investment risk. It is not clear whether the larger stock option grants and exercise price they receive are enough to make up for these sacrifices.

Resolving fairness problems is always difficult. Having longer exercise periods can both help and hinder fairness, depending on the situation. Any company that chooses to have longer exercise periods should consider implementing measures to revoke this benefit when it is undeserved by departing team-members. What is evident is that the argument against longer exercise periods based on the "wealth transfer" is not fully convincing.

About economics: Mitigating dilution through increased present value

The second concern — the economics of extended exercise windows and its effect on dilution — is also not complete. By considering the Present Value (PV) of stock options, a different approach can be pursued.

Specifically, extending the exercise window for stock options increases the chances for team members to benefit from their options. This is because the probability of a liquidity event (IPO, purchase, secondary sale, etc.) increases with time. Due to the time value of money, the PV of stock options with a longer (e.g. 10-year) exercise window would therefore be more than the PV of stock options with a shorter (e.g. 90-day) exercise window - all things being equal.

Due to the higher PV, startups could justifiably reduce the size of stock option grants in relation to market standards. This helps reduce the dilution effect on the options pool caused by the extended exercise period. It also addresses investor concerns and maintains hiring competitiveness by retaining more options in the pool.

By reducing the size of stock option grants and increasing the exercise windows, more employees will be able to benefit from their stock options, although the size of the individual grants would be smaller. This more equitable distribution would eliminate the stark contrast between employees who can exercise their stock options and those who cannot. This would ultimately increase the perceived value of Employee Stock Ownership Plans (ESOPs) as more individuals benefit from them. Additionally, this could enhance the overall perceived value of compensation packages without incurring any cost to companies.

Following this, there is a strong business case to increase exercise windows to benefit from the economics. The question is really not if this should be done, but rather how this should be done. 10 Year exercise windows are not always the best option. It will depend on the Startup to IPO timeframe a company expects, among other factors. In addition, arriving at a Present Value would require the company to make some impossible assumptions about the Future Value (FV), and the Rate of Return (r). Ultimately, the idea is not to try and engage in detailed financial modeling but rather to implement an approach that approximates future expectations and changes over time as more information becomes available.

Unintended consequences

Prisma’s decision to move to a 10-year exercise window was well-received internally, and it aligned clearly with our values and addressed some (although not all) concerns of our more "options-skeptic" European colleagues. However, it is not a panacea for all problems related to equity compensation. To ensure the health of our Stock Option, we needed to reduce the size of all stock option grants. An unintended consequence of this is that savvy employment candidates would compare the size of Prisma's grants to market data and correctly notice that the overall percentage of company ownership was less than what they might receive at similar companies. Fortunately, these same candidates were predominantly receptive toward the benefits accrued by the extended exercise window, and no offers were rejected on this basis. On the contrary, most candidates reacted positively to the approach when explained to them.

As Prisma approaches its 8-year anniversary in 2024, there are new challenges on the horizon. We are slowly approaching the 10-year post-grant limit for early employees, after which unexercised stock options are absorbed back into the company. This means that past employees will need to decide whether or not to exercise their stock options. If they choose not to, unexercised options will return to the options pool and render the fairness arguments made by Andreessen Horowitz irrelevant in the Prisma context. This situation will require us to reevaluate as we collect data on stock option exercise rates and their impact on the options pool.

Another concern arising from the extended exercise period is the large number of grant holders that need to be interacted with over a long period of time. There seems to be no meaningful way to mitigate this.

Overall, the 10-year extended exercise period has worked well in Prisma’s context, both in terms of fairness and economics. Partially because of our history, partially because we have strong European roots, and partially because of our culture. It is not for everyone, although we hope that our experience will start conversations for other companies to consider this approach.